The Role and Economic Benefits of Private Credit and BDCs
The private credit market has grown rapidly since the Great Financial Crisis of 2007-2008. By the end of 2023, private credit topped $2.1 trillion globally, about three-quarters of which was in the U.S., where its market share approached that of syndicated loans and high-yield bonds.
Why Companies Borrow from Private Lenders
In addition to private lenders providing access to credits that banks will not fund, corporations find benefits in private lending sufficient to offset the higher yields. Those benefits include:
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No mandated public disclosure of proprietary information;
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Less ongoing disclosure requirements are required for fundraising in the public market;
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Avoiding the time-consuming and expensive process of obtaining a rating from one or more of the rating agencies;
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The ability to customize the loan structure to meet the needs of the borrowing company, offering management greater flexibility; and
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A borrower facing financial difficulties will find it easier in a private debt transaction for management to do a workout with only one or a few lenders, compared to many lenders in a public bond offering.
BDCs
Business development companies, which were created by congressional legislation, are closed-end investment vehicles organized under the Investment Company Act of 1940. They have the following characteristics:
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BDCs raise debt capital in public markets to fund their portfolio investments. An advantage is that they have access to cheap government-sponsored debt financing, such as SBA debentures. BDCs also borrow through public debt instruments, revolving credit facilities, and term loans. They also raise capital in public equity markets.
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Unlike banks, BDCs do not face a high degree of maturity mismatch between their assets and liabilities. While a median loan originated by BDCs has a maturity of 5 years, the maturity of their liabilities fluctuates around 6 to 8 years for bonds and notes, 4 to 6 years for revolving credit, and 4 years for term loans.
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By being publicly traded, BDCs provide their investors with exposure to risk assets in a similar manner to private equity and venture capital, but with some increased liquidity. Investors also benefit from regulatory disclosures by accessing information on the BDCs portfolio strategy and end-use of funds.
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BDCs are often associated with large asset management companies managing other funds that target similar market segments, including other direct lending and private equity funds.
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They generally invest in so-called middle-market firms—typically with annual revenues between $10 million and $1 billion—through debt and, to a lesser extent, equity securities and derivative securities.
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They must invest at least 70% of their assets in nonpublic equity and debt of U.S. corporations.
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Eligible investments also include U.S. government securities, cash and listed securities of companies with a market capitalization of less than $250 million.
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BDC investment holdings are subject to diversification requirements.
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Senior secured loans form the majority (typically 70%-90%) of BDC portfolio assets today, though they may also hold subordinated debt as well as equity warrants and direct equity ownership in their portfolio companies.
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BDCs are permitted to use up to 200% leverage. Virtually all BDCs take advantage of a full turn (100%) of leverage. The use of leverage increases risk and drawdowns while also increasing expected returns.
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Ninety percent of BDC income must be derived from dividends and interest, and 90% must be distributed to shareholders.
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Managers are typically compensated through a combination of fixed and incentive-based management fees (percentage of net interest income and realized gains).
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BDCs are not allowed to issue shares to the public below net asset value (NAV) without annual shareholder approval.
Tetiana Davydiuk, Tatyana Marchuk, and Samuel Rosen, authors of the 2024 study Direct Lenders in the U.S. Middle Market, published in the December 2024 issue of The Journal of Financial Economics, examined the rise of direct lending using a comprehensive dataset of investments by BDCs. Their goals were to determine whether BDC capital can act as a substitute for traditional financing and whether the availability of private debt capital contributes to firm growth and innovation. They also investigated the factors that determine the propensity of BDCs to enter specific lending markets. They began by noting that private direct funds follow similar investment strategies as BDCs and enter areas subject to contractionary credit supply shocks—the similarity suggests that insights into the relatively opaque private debt space can be obtained through the lens of BDC investment allocations.
Their analysis relied on an extensive database of BDC investments hand-collected from publicly available filings, covering the period 2001-2017, and included 69 BDCs, about 10,000 portfolio firms, and over 20,000 individual debt investments. For each debt investment, they recorded such characteristics as debt type, deal size, industry, interest rate, and maturity date. They also determined the geographic areas in which BDCs concentrated their investment activity, hand collecting the exact addresses of their portfolio firms from BDCs’ capital registration statements. Here is a summary of their key findings:
BDCs invest in areas with a shortage of financing by traditional lenders—their capital can act as a substitute for bank lending. They target firms with high growth potential and innovative firms—BDCs can be particularly well-suited for firms active in high-tech and high-R&D-intensive industries.
Many BDC-funded firms previously received venture capital and private equity financing—about 30% of portfolio firms in the dataset. The capital allocation to the top 10 firms in a BDC portfolio ranged between 29% and 97%. In contrast, the largest allocation to a single firm was 16% on average—these are concentrated portfolios with significant idiosyncratic risk. The high concentration increases risk, allowing them to provide higher quality managerial assistance to their portfolio firms and giving them a more powerful role when negotiating distress situations.
Senior secured debt investments by BDCs can be viewed as equivalent to loans originated by traditional banks. The growth in senior debt investments was predominantly at the expense of riskier junior and subordinated debt.
Equity investments (typically warrants and preferred equity) on average represented 39% of all outstanding deals as of year-end 2017. One of the risk-management strategies implemented by BDCs is offering a debt security bundled with a warrant. In periods when a portfolio firm defaults on its obligations, a BDC can exercise a warrant to receive a stake in the firm and acquire the control rights, thereby offsetting some of its losses on debt securities. BDCs implemented this financing strategy with around 13% of portfolio firms in the sample.
BDCs invested in structured products such as collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs). In terms of the number of originated deals, the typical BDC held about 3%–4% of its portfolio capital in CLOs and CDOs.
A firms’ access to BDC funding stimulated their employment growth (BDC financing allowed firms to increase their employment growth by 0.8%– 1.2% per annum relative to the employment growth in the pre-investment period, with the positive effect present one year after the investment date and persisting for another two years) and patenting (innovation) contributing to economic growth—BDC-funded firms filed 2% more patents per quarter after obtaining funding, about a 10% increase from average patenting frequency.
Beyond credit provision, BDCs contribute to firm growth through managerial assistance. After controlling for firm and loan characteristics, public middle firms faced about 2% higher interest rates when borrowing directly from nonbank financial intermediaries than from traditional banks.
Their findings led Davydiuk, Marchuk and Rosen to conclude: “Our findings indicate that BDC capital plays an essential role in the growth of middle-market firms.” They also noted: “BDCs provide retail investors with access to illiquid investments in private firms.” Previously, access was only available to institutional investors.
While private credit borrowers benefited, how did BDC investors fare?
The Returns of Business Development Companies
Antti Suhonen, author of the study Direct Lending Returns, published in Volume 80, 2024, Issue 1 of the Financial Analysts Journal, examined the returns, risk exposures and performance persistence of BDCs. His database consisted of 47 BDCs (with about $112 billion of assets at the end of 2021) and covered the period December 2009 through June 2022. The following chart shows the market capitalization-weighted asset allocation of the 47 BDCs in the sample.
Here is a summary of his key findings:
BDC portfolio yield averaged 10.8% over the sample period (or average USD 3-month LIBOR + 10%). The yield dropped by four percentage points, from a high of 12.8% in 2012 to 8.6% in Q1 2022, before widening in the final quarter of the sample. The compression is likely in part a reflection of the improvement in BDC loan seniority (see above chart). The average BDC yield spread over leveraged loans during the sample period was 5.7%, ranging between 0.9% and 7.9%.
Since 2019 the debt-to-equity ratio averaged 102% versus 61% in 2009-2017. The increase in leverage is due to congressional action taken in 2019 that raised the leverage limit to 2.0 from 1.0.
The average annual management fee expense (including incentive fees) over the sample period was 3.19% of total assets, corresponding to 5.46% of net assets. This compares to an average management fee of 3.14% per annum of net assets for private direct lending funds.
The average financing expense was 4.36% per annum of total debt, or 3-month LIBOR + 3.58%, given an average LIBOR rate of 0.78% during the period.
BDC industry total returns at the market capitalization-weighted index level were 8.63% per annum with a Sharpe ratio of 0.38. The Sharpe ratio was well below that of comparable benchmarks such as leveraged loans (0.61) and high-yield bonds (0.63). BDC market value returns were best explained by a combination of liquid leveraged loan performance and equity market, size and value factors. Bundling the equity factors into one by using an equity small-cap value index as an explanatory variable alongside leveraged loans, the two regressors explained 81% of BDC market value index variation in monthly data and resulted in a negative but statistically insignificant alpha.
BDC volatility was broadly in line with that of small-cap equities. However, their returns exhibited more negative skewness and excess kurtosis than the equity benchmarks, though less than the leveraged loan index. Individual BDCs exhibited wide performance dispersion, with the difference between top and bottom quartile returns exceeding 15% per annum across different performance measures. Based on an NAV return metric, BDC performance exhibited strong year-on-year persistence, especially in the bottom and top quartiles of past returns.
There was a statistically significant relationship between valuation (price-to-NAV) and performance, with BDCs with greater price-to-NAV premium (or smaller discount) outperforming those with a smaller premium (larger discount) by all return metrics.
Investor Takeaways
Private corporate credit has created significant economic benefits by providing long-term financing to corporate borrowers. However, the migration of this lending away from regulated banks and more transparent public markets creates potential risks—valuation is infrequent (creating serial correlation of returns, which leads to understating volatility), and credit quality isn’t always clear or easily assessed. In addition, the rapid growth of private credit has spurred increased competition from banks (which have restored the health of their balance sheets since the great financial crisis). This competitive pressure could lead to a weakening of underwriting standards, looser loan covenants and lower spreads.
For investors, the key takeaways are:
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Once traded in the listed market, BDCs adopt the volatility of common stocks and may deviate from their fundamental value due to changes in investor risk aversion and market liquidity. The result is that they are riskier than the assets they hold, a problem compounded by their use of high amounts of leverage;
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BDC fees are extremely high fees relative to net investor assets (more than 5%)—though some of the incremental fees may be justified by the managerial value they can bring to the table; and
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Given the significant risks, investors should focus on credit quality, preferring to invest in only senior, secured loans.
It is hard to make a case for investing in public BDCs, especially when there are less risky and less expensive alternatives, such as Cliffwater’s Corporate Lending Fund (CCLFX) and its Enhanced Lending Fund (CELFX). The high expense ratio of BDCs is particularly egregious when it is applied to gross assets (as opposed to net assets). The reason is that gross assets include those that are financed with leverage that has had an average cost of about 3.6% above LIBOR. The result is that the investor is paying full fees on the leveraged assets when they are not earning the full yield paid by the borrower. In contrast, Cliffwater’s fees are applied to net assets.
The exception might be for a BDC than investments in loans to the lower end of the middle market, with loans typically being made to companies with less than $50 million in EBITDA and often only $10-20 million. Such riskier loans typically come with a significant “size” premium, typically in the form of warrants and/or preferred equity. A well-run BDC concentrating on this segment of the market can bring significant managerial assistance, justifying a higher fee. Star Mountain Capital is one such fund investors might consider.
* When I discussed this finding with Cliffwater’s CEO Stephen Nesbitt, he informed me that while the finding was correct for a buy and hold strategy, his research found that a periodic rebalancing strategy from high price-to-book to low price-to-book produced higher returns than a buy and hold strategy.
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